Roth Conversion—Much Ado about Anything?

This year, everyone seems so excited about the new guidelines for converting your traditional IRA to a Roth IRA. For those of you living in a cave, the new rule that took effect at the beginning of the year allows anyone to convert a traditional IRA to a Roth. Before 2010, you could only convert if your modified adjusted gross income was less than $100,000/year. Also, a “one-time special offer” allows the tax burden from the conversion to be spread over the next two years. While the new guidelines provide a potentially money-saving opportunity for some people, it’s far from the “no-brainer” that many financial columnists would lead you to believe.

A traditional IRA is typically funded by pre-tax dollars, providing a tax write-off when you make the contribution, but the withdrawals are taxed as ordinary income. They also require investors to begin withdrawing money at age 70 ½ in the form of required minimum distributions (RMD). To make matters worse, your withdrawals could push you into a higher tax bracket and force you to pay more taxes than necessary. On the other hand, a Roth IRA taxes the funds contributed at the time of contribution, with the promise of tax-free withdrawals in the future and no distribution requirements. It sounds like a slam dunk to convert, but everyone’s situation is different, making the answer to the question fuzzy and in need of case-by-case analysis.

Lifting the income restrictions for Roth conversions, and incentivizing the move even more with drawn out taxation, certainly makes sense for the government. During the next two years, the Federal and state governments will realize tax dollars they would not have seen for years from people who take advantage of the new laws. If enough previously excluded investors decide to make the move, it could mean a big near-term payoff for government, especially since far more money is tied up in traditional IRAs than in Roths ($3.7 trillion vs. $178 billion in 2006).

For the individual investor who can comfortably afford the immediate tax burden of conversion, and who is confident that those tax dollars are unlikely to serve a better, more efficient purpose, making the conversion seems like the logical move. But consider the uncertainty of the world we live in, and the nature of financial markets. Also consider a scenario a decade or two down the road where the government, in a similar situation to today, needs to generate revenue. They might not find it hard to justify taking money from rich people who are withdrawing massive amounts of tax-free money from their retirement accounts. Although an unlikely scenario, it forces you to look at the big picture and ask, “Why pay tax now if I can delay it?” Perhaps, 401(k) expert David Loeper said it best in a recent article: “With a highly uncertain future, basic option theory and common sense dictates that we should not pay additional tax now with certainty if we can avoid it, unless there is a clearly compelling advantage to doing so.” Don’t just go blindly and convert; do a thorough analysis and convince yourself that it really makes sense.

For most people, the analysis is too tedious and convoluted to spend time on, and most of the online tools are far too simplistic. If you have a financial advisor that you trust, he or she should do the analysis for you. If you are seriously considering conversion but don’t have a trusted financial advisor, it may be worth the cost to hire one just for this purpose. The fee may justify the wisdom of conversion, or it may save you from paying a lot of income tax today unnecessarily.